Congress Bickers, Bond Markets Brace for Panic: William D. Cohan

By William D. Cohan -
Jul 19, 2011

Hold on for just a New York minute
now and consider the powerfully serious message the bond market
sent last week about the political dithering in Washington and
in Europe’s capitals. “Pay attention folks,” as the investor
Gifford Combs e-mailed me on Friday. “This is not a drill.”

Here are the facts: The yield on Greek sovereign debt is
now at record highs for the euro era. Last week’s state-managed
bond auction in Italy almost failed. And, while few seem to have
noticed, the overnight repurchase market -- for short-term,
secured, corporate debt obligations -- nearly seized up amid
what Combs described as “an almost panicky scramble” for less-
risky paper.

Indeed, investors’ manic desire for safety last week
reached levels not seen since the most acute days of the
financial crisis in September and October 2008. Ironically,
though, given the pathetic display in Washington and the
country’s ongoing fiscal troubles, people turned in droves to
the perceived security of the U.S. Treasury market, even though
it has never looked shakier.

Remember the days of negative yields on short-term U.S.
paper -- when effectively investors paid the government to keep
their money safe? Warren Buffett considered that happenstance so
rare that two years ago at the Berkshire Hathaway Inc. annual
meeting he flashed a slide of a Treasury sale transaction ticket
to his legion of followers.

Negative Yields Return

Well, it seems those days are back. U.S. Treasury bills
shorter than three months in duration traded at negative yields
last week. Three-month bills were trading a yield of 1 basis
point. Six-month bills traded to yield 4 basis points and one-
year U.S. Treasuries were trading to yield 13 basis points.

In short, demand for the perceived security of the debt
obligations of the U.S. government was so intense that “it was
virtually impossible to find ANY amount of certain maturities of
short duration Treasury bills,” Combs informed me. He ended up
buying what he could of the one-year notes and paying big time
for the privilege (resulting in that minuscule 13 basis-point
yield).

Not everyone, however, seems to have so much faith in the
U.S. The Saudis appear to be so concerned that Congress and
President Barack Obama will not be able to reach a resolution on
increasing the debt-ceiling by Aug. 2 -- pushing the Treasury to
possible default on the nation’s obligations for the first time
-- that, according to market insiders, last week they Hoovered
up euros as a possible hedge. This helps to explain why the
European currency has managed to more than hold its own against
the dollar despite the continent’s economic woes.

Money-Market Worries

At the same time, it’s an open secret on Wall Street that
the Federal Reserve Bank of New York has become increasingly
concerned about the state of U.S. money-market funds. With as
little fanfare as possible -- understandably, so as not to cause
a panic -- the New York Fed has been urging domestic money-
market funds to reduce their exposure to European banks, where
the funds have turned to increase yields not available in the
U.S. because of rock-bottom interest rates.

The Fed is said to be terribly worried that -- because of
provisions in the Dodd-Frank law -- it will no longer be able to
rescue a money-market fund if it “breaks the buck,” as the Fed
did famously the day after Lehman Brothers Holdings Inc. filed
for bankruptcy.

Threat of Downgrades

As if all this were not enough, last week both Moody’s and
Standard & Poor’s put the U.S. itself on credit watch, with
negative implications about a possible downgrade. S&P said that
while it expected an agreement regarding the debt ceiling, it
was worried that the country’s fiscal house will remain in
disarray.

“Despite months of negotiations, the two sides remain at
odds on fundamental fiscal policy issues,” it stated in its
Bastille Day note. “Consequently, we believe there is an
increasing risk of a substantial policy stalemate enduring
beyond any near-term agreement to raise the debt ceiling.”

Additionally, on Friday, S&P put the six AAA-rated insurers
-- including New York Life Insurance Co. and Northwestern Mutual
Life Insurance Co. -- on the watch list for a possible downgrade
because of their significant holdings of U.S. Treasury and
agency securities. None of this is even remotely good news.

Charade in Washington

What is the bond market telling us? Combs, a founder of
Dalton Investments LLC in Los Angeles, likens the panic in the
bond market to the unambiguous message the stock market sent on
Sept. 29, 2008 -- when the Dow Jones Industrial Average dropped
780 points, the largest one-day point drop ever -- after
Congress voted down the first version of the TARP bill. That’s
how concerned the bond market is now about the charade going on
in Washington.

Combs worries, though, because of how inherently more
difficult it is for people to understand the machinations of the
bond market than those of the stock market, that the message
this time is not getting through to the politicians in
Washington, who seem intent on taking a nonchalant approach to
the potential Aug. 2 deadline for raising the debt ceiling.
(Some politicians -- hello, Michele Bachmann -- have actually
claimed that defaulting on our obligations would be good for the
country.)

Politicians Don’t Understand

His concern is that politicians don’t understand how
intimately tied transactions are on a worldwide basis to U.S.
Treasury securities, and that if Treasuries were no longer
accepted as collateral, the resulting market turmoil would make
the “collapse of Lehman Brothers look like a walk in the park.”

Combs said he believes a default on U.S. Treasuries would
set off “an unholy scramble” for what constitutes “good and
valid” collateral, creating a huge problem in the worldwide
payments system: “It’s a situation no one has ever faced before
-- that people stop accepting Treasury bills as collateral.”

Even though, incredibly, the politicians in Washington took
the weekend off from their negotiations, a bunch of them still
found the time to appear on the Sunday morning political talk
shows to make the case that a compromise will be found before
Aug. 2. We’ll see if they are correct -- but bond traders are
going to be increasingly less likely to bet on it.

(William D. Cohan, a former investment banker and the
author of “Money and Power: How Goldman Sachs Came to Rule the
World,” is a Bloomberg View columnist. The opinions expressed
are his own.)